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INFORM+INSPIRE
The Griffith Insurance Education Foundation
Risk Management Principles and The Role of Insurance
Washington, D.C.
April 29th, 2013
James M. Carson, Ph.D. CPCU, CLU, ARM
The University of Georgia
Risk
Focus on Fundamentals Some review of familiar terms / concepts
likely (see materials) Plus some new thoughts / concepts
Comments / Questions Welcome
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Risk is Ubiquitous
Personal/Individual Family Business Government
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Risk Risk
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Top 16 Most Costly Disastersin U.S. History(Insured Losses, 2012 Dollars, $ Billions)
$7.8 $8.7 $9.2 $11.1$13.4
$20.0$23.9 $24.6$25.6
$48.7
$7.5$7.1$6.7$5.6$5.6$4.4
$0
$10
$20
$30
$40
$50
$60
Irene (2011) Jeanne(2004)
Frances(2004)
Rita (2005)
Tornadoes/T-Storms
(2011)
Tornadoes/T-Storms
(2011)
Hugo (1989)
Ivan (2004)
Charley(2004)
Wilma(2005)
Ike (2008)
Sandy*(2012)
Northridge(1994)
9/11 Attack(2001)
Andrew(1992)
Katrina(2005)
Hurricane Sandy could become the 4th or 5th costliest event in US
insurance history
Hurricane Irene became the 12th most expense hurricane
in US history in 2011
Includes Tuscaloosa, AL,
tornado
Includes Joplin, MO, tornado
12 of the 16 Most Expensive Events in US History Have
Occurred Over the Past Decade
Insurance Information Institute. The Griffith Insurance Education Foundation
6
$8
.3
$7
.4
$2
.6 $1
0.1
$8
.3
$4
.6
$2
6.5
$5
.9 $1
2.9 $
27
.5
$6
1.9
$9
.2
$6
.7
$2
7.1
$1
0.6
$1
3.6 $2
5.0
$1
00
.0
$7
.5
$2
.7
$4
.7
$2
2.9
$5
.5 $1
6.9
$0
$20
$40
$60
$80
$100
$120
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11*20??
US Insured Catastrophe Losses
*Estimate through Oct. 31, 2011.Note: 2001 figure includes $20.3B for 9/11 losses reported through 12/31/01. Includes only business and personal property claims, business interruption and auto claims. Non-prop/BI losses = $12.2B.Sources: Property Claims Service/ISO; Insurance Information Institute.
2011 was one of the Most Expensive Year in History for Insured Catastrophe Losses in the US
$100 Billion CAT Year is Coming Eventually
Record Tornado Losses Caused
2011 CAT Losses to Surge
($ Billions)
2000s: A Decade of Disaster2000s: $193B (up 117%)
1990s: $89B
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Underwriting Gain (Loss)1975–2012:Q3*
* Includes mortgage and financial guaranty insurers in all years.Sources: A.M. Best, ISO; Insurance Information Institute.
Large Underwriting Losses Are NOT Sustainable in Current Investment Environment
-$55
-$45
-$35
-$25
-$15
-$5
$5
$15
$25
$35
75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Cumulative underwriting deficit from 1975 through
2011 is $479B
($ Billions) Underwriting losses
through 2012:Q3
totaled $6.7B
High cat losses in 2011 led to the highest
underwriting loss since 2002
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What is Risk?
Traditional Definition Risk = Uncertainty
Risk of Death?
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What is Risk?
A Better Definition Risk = Uncertainty about chance, timing,
or amount of loss Risk of ____ death Risk of poor health Risk of car accident Risk of house fire Etc…….
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Types of Risk
Objective risk v. Subjective risk Pure risk v. Speculative risk Property risk (direct v. indirect) Liability risk
(Ex: Corps of Engineers, Deepwater Horizon Spill)
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The Burden / Cost of Risk on Society Need for Emergency Funds Outlays to Reduce Risk Opportunity Cost Expense of Financing Potential / Actual Losses Increased Prices Loss of Certain Goods & Services Worry and Fear Time Losses For Which We Are Not Indemnified
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Benefits of Managing Risk
Potential Enhancement of Credit Indemnification for Losses Less Worry and Fear—More Activity Source of Investment Funds
(~$6 T Assets) Loss Prevention Services
Private Efforts Public Efforts (Ex: flood mitigation)
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Risk ManagementRisk Management
Risk Management
Definition: Formal decision-making process to
identify risk and minimize the cost of risk, including the potential financial consequences associated with loss exposures
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Risk Management Process Identify loss exposures and select the most
appropriate techniques for treating such exposures
Broader than simply Insurance Trend toward “Enterprise Risk Management”
Loss Exposure: Any asset exposed to loss; any situation in which a loss
may occur
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The Griffith Insurance Education Foundation
Risk Management Process
Implement and Monitor
Identify
Evaluate
Select a Technique
AvoidRetainTransferControl
Insurance
Other Contractual
Evaluating Loss Exposures Loss Frequency
Car accident occurs every 5 _____ in U.S. For most drivers, though, low frequency, 1 in
10 years
Loss Severity Maximum Probable Loss Maximum Possible Loss
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The Griffith Insurance Education Foundation
Select Appropriate Technique: The Risk Management MatrixSelect Appropriate Technique: The Risk Management Matrix
Frequency
Severity
High
Low
LowHig
h
Retain Control/Retain
Insurance Avoid
Select an Appropriate Technique
Retention Why would you/someone/firm retain risk? How Much Can be Retained? (Financial Capacity) Active vs. Passive Retention vs. Self-Insurance (Formal) Disadvantages
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The Insurance Mechanism
Definition: The pooling of fortuitous losses By transfer of risks to insurer Insurer agrees to indemnify for covered
losses
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Basic Elements of Insurance
Pooling of losses Losses are shared by the pool Substitutes average loss ($xxx) for actual
loss ($30,000 car)
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Basic Elements of Insurance
Replaces uncertain loss (risk) with certain payment (premium)
Unique in that pricing before the fact—don’t really know costs until after product is sold
Insurer uses law of large numbers and past experience to estimate premiums
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The Griffith Insurance Education Foundation
Pricing of Insurance – An AnalogyPricing of Insurance – An Analogy
Card Value # of Cards Prob Exp ValueNon-Face $0 36 0.667 $0Jacks/Queens -$100 8 0.148 -$15Kings -$250 4 0.074 -$19RedAces -$1,000 2 0.037 -$37BlackAces -$2,000 2 0.037 -$74RedJoker -$5,000 1 0.019 -$93BlackJoker -$20,000 1 0.019 -$370
54 1.000Average (Expected Value) -$607
• Substitutes average loss ($607) for actual loss
Insurance Prices (Rates)
Objectives: Adequate, not excessive, not unfairly discriminatory
Conflicts among these goals
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Insurance Prices (Rates)
Methods vary by state and line of business
Personal lines generally are more strictly regulated than commercial lines
Often more concerned with rates that are too low rather than too high
Remaining insurers pay claims of failed insurers
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Basic Elements of Insurance… Surplus
Insurer “Net Worth” = Owners’ Equity = A – L For U.S. P-C Insurance Industry, ~$600 B If, at end of the year (policy period):
Losses > expected, fund balance (“Surplus”) goes down
Losses < expected, fund balance (“Surplus”) goes up
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Basic Elements of Insurance
“Surplus” is the Insurance Mechanism’s “Cushion” and is what enables insurers to offer insurance
Premium / Surplus ratio concept (leverage)
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‘Requirements’ of an Insurable Risk Large Number of Homogeneous Exposure Units Accidental and Unintentional Loss Determinable and Measurable Loss Calculable Chance of Loss Economically Feasible Premium
If calculated premium is too high, probably trying to insure something that is best
_______ Best suited for risks that have __S and __F
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Adverse Selection
Definition: Phenomenon whereby people with
higher-than-average chance of loss are more likely to seek insurance than average risks (e.g., ……)
i.e., the non-face cards don’t buy insurance, then the pool doesn’t collect $607 * 36
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Adverse Selection
Consequences Results in higher losses & expenses than
expected Prices increase “Better” risks drop out of pool, prices increase….
”Death Spiral”
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Controlling Adverse Selection
Underwriting Involves selecting and classifying insurance
applicants Certain standards that must be met for
“standard” rates If better than “standard,” lower rate applies If < “standard,” higher rate applies
Policy Provisions E.g., Suicide clause in life insurance
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Key Points about Adverse Selection
Risk pooling doesn’t work if the risk is too high Risk pooling doesn’t work with too many high
risks Insurers need to be able to identify risk type so
that they can put similar risks together in a pool to make it fair and affordable
Competition will drive premiums to the appropriate level for risk type
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The “Moral Hazard” Problem Definition: Behavior change due to the
presence of insurance that increase the frequency or severity of loss
Examples: Faking accidents, disability Exaggeration of claims Failure to control losses (not locking car or
house) Intentional losses Overutilization of insurance (e.g. health)
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Controls on Moral Hazard
Can’t insure in excess of the loss Limits on underinsuring property Careful claims adjusting Deductibles and coinsurance Waiting periods Exclusions Limits Riders
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Societal Costs of Insurance
Cost of Claims Outlays to Reduce Risk (Loss Control) Increased moral hazard
Changes in behavior
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Societal Costs of Insurance….. Cost of Ins. Mechanism --“Expense Load”
Cost (Expenses, Profits, Contingencies), including Inflated / Fraudulent Claims Insurers do not “pay” claims We pay claims Anything that increases outflow must have an
inflow EX: To insure expected losses of $5,000 would
require premium of more than $5,000; so, for example, $5,000 + ~20% = ~$6,000
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Brief overview of Basel 3
Capital standards Primarily geared toward banks Gets applied to some insurers via Dodd-
Frank Act
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Basel 3 cont…
Authorizes Federal Reserve Board regulation of Savings and Loan Holding
Companies (some of which own life insurers)
Nonbank Financial Companies (may include insurers that are deemed systemically important by the Financial Stability Oversight Council)
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Basel 3 cont…
Some Issues Risk-Based Capital (RBC) and
FAST exist for insurers Long-term Assets vs. Short-term
Assets Bank-type regulation at federal
level vs. insurer-type regulation at state level
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Thank you.
For more information contact:
The Griffith Insurance Education Foundation
7100 North High Street, Suite 200
Worthington, Ohio 43085
Phone: 855-288-7743
Email: [email protected]
To download today’s presentation, please visit www.griffithfoundation.org/resources
INFORM+INSPIRE
The Griffith Insurance Education Foundation
Risk Management Principles and The Role of Insurance